Download gross fixed capital formation

Macroeconomics:
concepts and measurement
École des Hautes Études Commerciales (HÉC),
MBA Program, October 2001
Macroeconomics: the basic concepts
of national accounting
What macroeconomics is about
Macroeconomics studies the overall performance
of national economies.
 In order to get a global understanding of how a
national economy works, macroeconomics does four
things:

– It groups economic agents in broad categories
(households, firms, governments and non-residents).
– It merges thousands of individual markets into larger
aggregate markets (the market for goods and services,
the labor market, the domestic and foreign financial
markets, etc.).
– It focuses on the variables which tend to affect large
segments of the national economy (the price of foreign
currency, the level of real interest rates, etc.).
– It stresses the interdependence between markets.
An illustration: the circular flow model
of income and expenditure

The circular flow model of income and expenditure
is a good starting point to understand the concepts of
aggregate markets and interdependence.

In its simplest form, the model considers only two
sectors: the households and the firms.

Furthermore, it abstracts from saving considerations.

Here it goes.
AGGREGATE INCOME
(monetary flow)
PRODUCTIVE SERVICES
(real flow)
FIRMS
HOUSEHOLDS
GOODS AND SERVICES
(real flow)
AGGREGATE SPENDING (consumption)
(monetary flow)
In this simple model:

We can identify two markets implying the
exchange of a real flow against a monetary flow.
– The labor market where households exchange their
productive services (real flow) against an income
(monetary flow).
– The market for goods and services where the firms
exchange the goods and services they produce (real
flow) against an income (the monetary flow).

The two monetary flows are equal:
Aggregate income = Aggregate expenditure
AGGREGATE INCOME
(monetary flow)
PRODUCTIVE SERVICES
(real flow)
FIRMS
HOUSEHOLDS
GOODS AND SERVICES
(real flow)
AGGREGATE SPENDING (consumption)
(monetary flow)
The equality between income and
expenditure

Why did we obtain the equality between aggregate
income and aggregate expenditure ?
– Notice that we did not consider the non-residents. The
firms are therefore owned by the domestic residents and
any revenue not paid in wages is necessarily a profit
earned by the domestic household sector.
– We did not consider saving: All profits are distributed and
all income (wages and profits) is spent on consumer goods
and services.

Because of the equality between aggregate income
and aggregate expenditure:
– Any event affecting the labor market will affect the market
for goods and services and vice versa. Examples ?
AGGREGATE INCOME
(monetary flow)
Discussion in class
PRODUCTIVE SERVICES
(real flow)
FIRMS
HOUSEHOLDS
GOODS AND SERVICES
(real flow)
AGGREGATE SPENDING (consumption)
(monetary flow)
Adding complexity: Saving and gross
fixed capital formation

In general, the firms save a portion of their profits:
retained earnings

The households do not consume all of their income:
households saving

The sum of these savings can finance another type of
expenditure:
gross fixed capital formation
Gross fixed capital formation and
investment

By gross fixed capital formation (GFCF) we mean the
purchase of physical assets which increase the
productive capacity of the economy (investment
goods):
– Expenses made to build residential and non-residential
structures, to acquire machinery and equipment, etc.
Investment spending is a slightly larger concept as it
also includes the change in the value of final goods
inventories (with saving, income earned in one period
can be spent in the next period).
 Many firms and households finance their investment
spending with their own saving.
 However, it is the role of financial markets to
intermediate between agents who save more than they
invest and agents who invest more than they save.

AGGREGATE INCOME
(monetary flow)
PRODUCTIVE SERVICES
(real flow)
Households
saving
Firms saving
FIRMS
HOUSEHOLDS
Gross fixed capital
formation +  inventories
GOODS AND SERVICES
(real flow)
AGGREGATE SPENDING
(monetary flow)
What has changed ?

Fundamentally we have added a third aggregate
market, the financial market whose role is to channel
excess savings towards investment.

Within the aggregate market for goods and services,
we have introduced a distinction between consumer
goods and investment goods (productive physical
assets).

The equality between aggregate income and
aggregate expenditure remains but the latter is now
defined as the sum of consumption, gross fixed
capital formation and  inventories.
Adding the government sector
Here we state the general principles without spelling
out the details onto the diagram.
 What does it change to add the government sector ?

(excluding public enterprises which we have included in the
firms sector):
– Not all income earned by the firms and the households is
available for “private” consumption or saving. The
government is taking its share by taxing firms and
households.
– On the other hand, the government is transferring part of its
tax revenues back to the households and firms.
– Net government revenue is equal to the difference between
taxes and transfers.
– The government is using its net revenue (plus the funds it
borrows in case of a budget deficit) to finance public
consumption and public gross capital formation.
Adding the government sector
– The equality between aggregate income and aggregate
expenditure is not affected except that we must now include
government expenditures (public consumption and public
gross capital formation) in the definition of aggregate
expenditure.

It’s time to sum up before introducing the nonresidents sector:
– Let’s denote private consumption by C, public consumption
by G and gross fixed capital formation (public and private)
plus  inventories by I.
– When there are no relations with the non residents:
Aggregate expenditure is equal to C + I + G
 Aggregate expenditure is equal to aggregate income

– The introduction of the non-residents changes these results.
Introducing the non-residents:
the balance of payments
The transactions between the residents of a country
and the residents of the rest of the world are
recorded into the balance of payments.
 We make a distinction between two general types of
transactions:

– Current transactions (recorded in the current account).
– Capital and financial transactions (recorded in the capital
and financial account).

For now we will consider only the current account,
the capital and financial account will be treated in
more details later in the course.
The current account
The current account of a country constitutes its
consolidated statement of income and expenditure.
 A country receives an income from the non-residents
whenever:

– It exports goods and services.
– The non-residents pay for the use of the factors of
production (capital and workers) owned by the residents.
– Transfers are received from the non-residents.

The same country spends whenever:
– It imports goods and services.
– The residents pay for the use of the factors of production
(capital and workers) owned by the non-residents
– Transfers are made to the non-residents.
The current account

The current account (CA) results from the
consolidation of these sources of income and
expenditure:

CA = NX + NFP + NT
– where NX (net exports) is the difference between all
exports of goods and services and all imports of goods
and services.
– NFP (net factor payments) is the difference between the
factor payments (payments made to workers and capital
owners) received from and made to the non-residents.
– NT (net transfers) is the difference between the transfers
received from and the transfers paid to the non-residents.
Canada’s current account
2000 (Can$ m, source: Statistics Canada’s Web site)
Revenues
Exports goods
Exports services
Factor (investment) income earned
Current transfers earned
Expenditure
Imports goods
Imports services
Factor (investment) income paid
Current transfers paid
Current account
NX
NFP
NT
422 559
55 291
42 336
6 043
363 281
62 005
69 458
4 591
+ 26 894
+ 52 564
- 27 122
+ 1 452
The current account and the
equality between aggregate income
and expenditure

Before considering the non-residents, we had found
that aggregate expenditure was equal to C+I+G.

These expenditures were made by the domestic
residents only. Therefore and from now on, we will
define C+I+G as domestic absorption (DA):
– DA = C + I + G

Let’s add net exports to domestic absorption:
– DA + NX = C + I + G + NX

How should we interpret this sum ?
The current account and the
equality between aggregate income
and expenditure
NX is the difference between all exports (X) and all
imports (M).
 We can re-arrange the terms of the equation defining
DA + NX in the following way:
 DA + NX = [ (C+I+G)-M ] + X.
 The term in square brackets is domestic spending on
goods and services from which we have netted out
imports. These are the expenditures made by the
domestic residents to buy domestic production only.

The current account and the
equality between aggregate income
and expenditure



The second term is the expenditure made by the nonresidents to acquire domestic goods.
Summing the two terms we thus obtain the value of all
expenditures made to acquire domestic production. The
value of DA + NX is therefore equal to the value of
domestic production.
The value of domestic production is a very important
concept in macroeconomics. We call it Gross Domestic
Product (GDP). We just learnt that we can measure
GDP by summing domestic absorption and net exports:
GDP = C + I + G + NX
A breakdown of Canada's nominal GDP
(2000, by expenditure type)
-39,9%
56,1%
44,5%
18,2%
0,9%
C
G
GFCF
20,3%
Inventories
X
M
The current account and the
equality between aggregate income
and expenditure
 GDP,
the value of domestic production, is the
primary source of income for domestic residents.
 However, as we have seen with the current
account, this is not the only source of income.
 For this reason, we can non longer say that
aggregate expenditure (now DA+NX) is equal to
aggregate income.
 The two remaining components of the current
account (NFP and NT) must be added to GDP in
order to obtain aggregate income.
The current account and the
equality between aggregate income
and expenditure
 Summing
NFP to GDP:
 Summing
NT to GNP
– GDP + NFP = (C + I + G) + (NX +NFP)
– We call this new term Gross National Product (GNP)
– Conceptually, GNP is the value of the income earned
by the domestic residents from the use of their factors
of production.
–
–
–
–
GNP + NT = GDP + NFP + NT
GNP + NT = (C + I + G) + (NX + NFP +NT)
GNP + NT = DA + CA
We call this new term Gross National Disposable
Income (GNDI).
– Conceptually GNDI is the total revenue a nation can
use either for consumption or for saving purposes.
A useful interpretation of the
current account
 GNDI
= (C + I + G) + CA
 Subtract C and G from both sides:
 (GNDI - C - G ) = I + CA
 The portion of GNDI which is not
consumed (either C or G) is called national
saving (S).
 We obtain ( S - I ) = CA
 Interpretation ?
Summing up

GDP is the value of domestic production and the
primary source of income for the residents of a
country.
– GDP can be measured as DA + NX, that is (C+I+G)+NX.

GNP is the value of the income earned by the
domestic residents from the use of their factors of
production (which can either be used domestically
(GDP) or abroad (NFP).
– GNP = GDP + NFP

Gross national disposable income is the value of the
revenue a nation can use either for consumption
or for saving purposes.
– GNDI = GNP + NT = (C+I+G) +CA

The current account can be interpreted as the
difference between national saving and investment
– CA = S - I
Macroeconomics: Measurement issues
Among the indicators used to assess a
performance, three are particularly important:
country’s
The growth rate of GDP
The rate of inflation
The unemployment rate
The unemployment rate will be addressed later in the course.
We start with the first two indicators.
GDP and its growth rate
We saw that we could measure GDP by summing DA
(C+I+G) and NX (X-M).
We now mention that only the expenditures which buy final
goods and services are to be included.
Purchases of intermediate goods (intermediate from the
point of view of the domestic economy) should not be
counted because this would result in the overestimation of
the value of production.
Why ? (A few examples ?)
GDP and its growth rate
Now, there is a trickier problem.
Since GDP is the value of domestic production, it can
increase for two reasons:
The volume of production increases
Prices increase
Economic growth refers to the growth in the volume of
production, not the growth in the level of prices which would
be pure inflation.
We solve this problem by constructing two GDP series
One in which the numerous components of
expenditures C, I, G, X and M are measured at current
prices.
Another one in which the same quantities are
measured at constant prices (brief discussion of the new
method).
GDP and its growth rate
GDP measured at constant prices is called real GDP and
GDP measured at current prices is called nominal GDP.
Usually, GDP is measured every quarter expressed in
annualized terms, the yearly figure being the simple average
of the four quarters.
The GDP growth rate can be computed:- sometimes over the previous quarter (quarterly growth
figures)
- more often over the same quarter of the preceding year
(yearly growth figures)
When economists refer to economic growth, they refer to the
growth rate of real GDP, not of nominal GDP and a recession
refers to an episode of negative real growth lasting at least
two consecutive quarters.
Canada’s latest GDP growth statistics
The inflation rate
Inflation is defined as a sustained process of increases in the
average level of prices.
In order to track the evolution of the average level of prices,
we construct various price indices among which we can cite
the consumer price index (CPI) and the GDP price deflator.
We first explain how we measure the GDP price deflator.
Later we discuss the differences between this particular price
index and the consumer price index.
The inflation rate
Computing the GDP price deflator is quite simple once we
know nominal and real GDP.
The price deflator is computed as:
P = ( Nominal GDP / Real GDP )
As we usually want the price index to be equal to 100 for the
base period, we multiply the result by 100.
GDP price deflator = P • 100
The growth rate of this index is one particular measure of the
rate of inflation.
Inflation measured by the consumer
price index
Even if the rate of inflation measured by the GDP
price deflator is important, it is the rate of inflation
measured by the consumer price index which attracts
most attention.
The consumer price index is based on the cost of a
fixed basket of goods and services bought every month
by a typical household.
Again, a base period must first be chosen.
The value of the index for a particular period is
computed by dividing the cost of the basket in that
period by its cost in the base period, the result being
multiplied by 100.
For the base period, the value of the index is obviously
equal to 100.
The consumer price index: a simplified example
Base period
Current period
Item
Quantity
Price
Cheese
2 kilos
10$/kilo
Water
12 liters
1$/liter.
Metro
25 tickets 1,50$ each 37,50$
Total
CPI
Cost
Quantity
Price
20,00$
2 kilos
11$/kilo
12,00$
12 liters
1,50$/liter. 18,00$
25 tickets
2,00$ each 50,00$
69,50$
(69,50/69,50) * 100 = 100
Cost
22,00$
90,00$
(90,00 / 69,50) * 100 = 129,5
Inflation measured by the consumer
price index
Usually, the consumer price index is measured every
month and the rate of inflation is computed as its
growth rate
- over the previous month for monthly inflation
- over the same month of the preceding year for
yearly inflation
- we can also compare the 12-month average of a
particular year with the 12-month average of the
preceding year
Canada’s latest CPI inflation statistics
Macroeconomics:
concepts and measurement
École des Hautes Études Commerciales (HÉC),
MBA Program, October 2001